A Rose By Any Other Name  

(A Thorny Proposition)

By:  Barry Marks  

Let's begin with the simple stuff:  there must be a million names for leases with $1 purchase options, balloon payments and the like.  Right there we have a problem:  under state law a lease with a "nominal" purchase option is a secured financing and not a true lease.  UCC �1-203 (formerly, 1-102(37)) provides that a lease in which the lessee may acquire the leased property at the end of the term for nominal consideration is actually a secured loan.The IRS takes a different view, successfully arguing in many cases that a "bargain" purchase option is enough to establish that the lessee, and not the lessor, is the owner of leased property for federal income tax purposes.

All that being said, the list includes the following.  (We would love to hear from others what can be added to the list)

$1 Purchase Option Lease

$1-out Lease

A Loan in Lease Clothing (actually, this one is suspicious but I suppose David may be right and it is used by somebody)

ALIAS (a lease intended as security)

Buck-out Lease

Capital Lease (often incorrect usage - this is an accounting term)

Collateral Lease

Conditional Sale Lease

Direct Finance Lease (which refers to a number of additional issues, potentially)

Dirty Lease

Disguised Lease

FAS-13 Finance Lease

Finance Agreement

Finance Lease (old usage - it means true 3rd party lease under UCC 2A) 

Financing Arrangement

Financing Lease

Full-payout Lease (which is misleading as these leases can contain FMD purchase options in which case they may or may not be true leases)

Hire-for-Purchase (Canada and British-influenced countries - thanks Jon)

Installment Sale Lease

Lease Intended as Security (often called "ALIAS")

Lease-Purchase

Mandatory Purchase Lease

Money-over-money Lease (I had forgotten this one - thanks, Jeff) 

Nominal Option Lease

Non-operating Lease (see "Capital Lease") 

Non-true Lease

Not-true Lease

PUT Lease ( Payment-Upon-Termination - caveat a "PUT" for FMV or more than FMV can be a true lease) 

Sales Finance Lease

Synthetic Lease (which opens another can of worms and is largely accounting-driven)

When we raised this issue on ELFA's Legal Talk Listserve, Stewart initiated a very interesting conversation on why anyone would use one of these leases rather than an Equipment Finance Agreement.  As discussed in our article in the Journal of Equipment Lease Financing several years ago, the popular [use your favorite term] lease may well be on the way out for several good reasons.  State tax authorities are easily (and often deliberately) confused by these transactions.  They often insist on taxing the rent stream, including the finance charge/imputed interest, rather than taxing the purchase price of the equipment only.  Where the lessee enjoys some form of tax exemption from the state, the use of a [whatever] lease can result in frustrating conversations with taxing authorities and angry customers.  Remedies sections and casualty value computations under traditional leases can lead to confusion and might result in unenforceable penalties rather than proper liquidated damages or recompense. (See article next month on damages.)

On the other hand, it is not at all uncommon for a lessee who will send a $1 million line of credit to its counsel to sign a $10 million "lease" without batting an eye.  In some cases, executives who do not believe they have authority to borrow money are willing to do just that through nominal lease transactions.  As Teresa noted, there are concerns regarding confused and increasingly aggressive bankruptcy trustees and the rules among state tax authorities may be entirely different from those used by other state officials.  In fact, a senior sales tax bureaucrat in the Great State of Tennessee actually said to me "the UCC definition may be the law but we don't follow it."  Huh? 

The simple fact is that the [call it what you will] lease is going to be around for quite some time although a big chunk of its popularity has shifted to Equipment Finance Agreements.  As we have noted in past issues, however, an EFA can run afoul of bankers who do not understand why they cannot use a Note and Security Agreement and too often lawyers prepare EFAs that begin with lease language and do not make all of the necessary changes to effect a proper lending agreement.  Finally, there is the issue of whether the equipment finance industry is really distinguishable from the straight lenders if we are using essentially the same documentation.  This is more of a problem for internal bank leasing departments than anywhere else.  For more on that, our next issue will include an article on how bank leasing differs from bank lending and what leasing company subsidiaries should consider before integrating their operations into their bank. 

The age old adage about "death and taxes" continues to hold true. As a lender or finance company, the ability to understand the federal government's power to attach liens upon your borrower's property, aka your collateral, is of the utmost concern. This article provides a brief overview of general areas of legal concern and introduction into federal tax liens.  

A federal tax lien arises when any person or company fails to make payment after demand by the government of any federal tax.  See IRC � 6321. The lien attaches to  all property and rights to property of the taxpayer, including property acquired after the tax lien arises and after a Notice of Federal Tax Lien is filed.. This broad concept of "property and rights to property" routinely is interpreted by the courts to include personal property, tangible and intangible property, real property and other rights to property.  The concept of "property" is determined under state law, not federal. For example, in many states a liquor license is not property so it is not subject to a federal tax lien.. However, if under state law the taxpayer does have property rights in a liquor license then it is subject to the lien. See Drye v. United States, 528 U.S. 39 (1999).    Our advice is that if your customer has a federal tax lien,  assume any property you finance under a sale/leaseback or take as collateral in a loan or EFA is subject to the lien. In essence, federal tax liens create a "blanket" lien over all property of the taxpayer.[1] 

 II.  Priority of Federal Tax Liens

Due to the ease at which federal tax liens attach to a taxpayers property, providing adequate assurances that your interest takes priority is critical.  To create priority over competing claims the government must file a Notice for Federal Tax Lien ("NFTL"). Similar to a UCC-1 financing statement, a NFTL is a "notice" system to provide for the "first in time, first in right" principle. The majority of states have adopted the Uniform Tax Lien Registration Act, which governs the location of filing for the NFTL. Unlike a UCC-1 financing statement for a business entity, the filing does not occur in the state of organization but rather in the location of the executive principal office. This is important when performing your due diligence in searching for federal tax liens as it can be the difference in taking priority over a federal tax lien. In order to perfect the tax lien on real property, the NFTL must be filed in the real property records in the manner provided under state law - usually in the counties where the taxpayer owns real estate.

Property subject to a federal tax lien also includes transferred and substituted property. If a taxpayer sells property, the tax lien will attach to whatever is substituted for it.[2]  If the tax lien is perfected, it can stay attached to property in the hands of a purchaser under varying circumstances. So, even if your borrower has no tax liens, your security interest could be subject to a federal tax lien that follows the asset from the person that sold the equipment to your customer.  For the reasons we discuss below, you should generally be fine if the asset is acquired from a vendor or manufacturer in the normal course of business. But keep this in mind if you customer  purchases assets from someone selling equipment they have been using, particularly if the seller is a distressed company. 

To determine if a party holds a prior valid security interest that takes priority against a federal tax lien one must look to state law. A security interest must be protected under state law as against a subsequent judgment creditor and the holder must have parted with money for a security interest to be valid. See Treas. Reg. � 301.6323(h)-1(a)-3. Additional protection is given to a subsequent holder of a security interest, even if the subsequent holder knew of the federal tax lien, as long as the initial holder's security interest was valid. As always, perfect your security interest so you do not lose priority to liens arising after your transaction, including federal tax liens. If you have any specialized questions on what constitutes a valid "security interest" or other hypothetical please let us know.  

Purchasers generally take free and clear of federal tax liens if the sale is completed before the government files a NFTL.. The Internal Revenue Code defines "purchaser" as a person who, for adequate and full consideration in money, acquires an interest (other than a security interest or lien) in property which is valid under state law against subsequent purchasers without actual notice of the federal tax lien.  The IRS provides guidance for the term "purchaser." IRS Manual 5.17.12 states, "A purchaser must acquire the property pursuant to a sale which bears a reasonable relationship to the value of the property acquired but does not preclude a bona fide bargain purchase or one who has not completed performance of ones obligations, such as in installment payments." It is worth noting that a holder of a security interest can not qualify as a purchaser. We have been asked by clients looking to help borrowers finance property subject or about to be subject to federal tax liens whether selling the property and leasing it back or otherwise shuffling ownership around will work. The simple answer is "don't try it."

Contained in the Internal Revenue Code, ten super priorities exist that can prime a federal tax lien even if the Notice of Federal Tax is filed prior to your interest arising. See IRC � 6323. This list includes the purchasers of securities and motor vehicles, retail purchasers and other protected classes.  In the event that your transaction falls into more than one category of super priority, the category that gives your interest the greatest protection will apply. Only categories that deal with sale of tangible personal property (e.g., goods) in a non-consumer setting will be discussed below.

               a.  Purchasers of Motor Vehicles

A purchaser of a motor vehicle can take priority over a federal tax lien.  Federal tax liens are not noted on certificates of title;  so, the law protects innocent purchasers who purchase a vehicle with a "clean" title.   To prime a federal tax lien a  "[P]urchaser  must at the time of purchase not have actual notice or knowledge of the existence of such lien, and have actual possession of the motor vehicle and thereafter not relinquish possession of the motor vehicle back to the seller or his agent." IRC � 6323 (b) (2).  In order to prime the tax lien it is critical that that the purchaser 1) have no knowledge of the lien and 2) take  possession of the vehicle. To determine purchaser status, a court will focus on not only the fair market value tendered for payment but also on the facts and circumstances of the transaction as a whole. See Marietta v. United States, 1987 U.S. Dist. LEXIS 15129. Also, never lease the vehicle back to the seller; this will defeat your priority over the federal tax lien.

               b.      Purchaser at Retail Sale

A purchaser of tangible personal property, such as business equipment, at a retail sale is given a super priority over a federal tax lien unless the purchaser knows or intends that the purchase will hinder, evade or defeat the collection of the federal tax. See IRC � 6323 (b) (3). Retail sale is defined as, "[A] sale made in the ordinary course of the sellers business of personal property of which the seller is the owner. It includes a sale in the retail quantities by a seller who is going out of business but not a bulk sale or an auction where quantities are substantially larger than are customary in the ordinary course of the seller's business or auction where the owner is not in the business of selling such goods. Treas. Reg. � 301.6323(b)-1.  For example, if you purchase a computer from a dealership that is subject to federal tax liens, as long as it is made in the ordinary course of business and you do not posses intent to evade the federal tax liens, your interest will prime dealerships federal tax lien.

              c.  Purchase Money Security Interests

Although not expressly codified in in the Federal Tax Lien Act of 1966, a super priority is given to the holder of a perfected purchase money security interest ("PMSI")[3]. In IRS Revenue Ruling 68-57, the IRS stated, "a purchase money security interest valid under local law given in good faith to secure a loan for the purchase of goods takes priority over a previously recorded Notice of Federal Tax Lien."  The critical inquiry for a PMSI is that it is valid under state law. This super priority will prime a federal tax lien and leave your interest with priority.  PMSI's generally require an advance of money or credit that enables the debtor to purchase goods and the advance of money is actually used to acquire the specific goods. See UCC � 9-103.  To prime a NFTL, the PMSI must still be properly perfected within the statutory period under state law. If the transaction is one in goods (moveable property, such as piece of equipment), the customary routine is filing a UCC-1 financing statement within the statutory time frame from the debtor obtaining the goods, usually 20 days. See UCC � 9-317, 9-324. If these procedures are followed, a federal tax lien will be primed.  

EVEN THOUGH SPECIAL PROTECTIONS CAN PRIME A FEDERAL TAX LIEN, IT IS ALWAYS BETTER TO TAKE SEARCH FOR NOTICE OF FEDERAL TAX LIENS BY SEARCHING IN THE STATE OF YOUR BORROWER'S PRINCIPAL EXECUTIVE OFFICE. THESE SEARCHES ARE INEXPENSIVE AND PROTECT YOUR PRIORITY.